Islamic finance rides the storm – SMH – 11 Oct.08

A thriving financial sector sounds like an oxymoron these days. Even Australia’s banks – among the most profitable in the world – kept a fifth of this week’s interest rate cut to cushion their margins. But there is one sector that has tongues wagging in the hubs of commerce: Islamic finance.

While the Western world’s financial system has been imploding, this small but rapidly growing share of world capital has weathered the storm.

Sharemarkets in London and New York are a third off their peaks. Dow Jones’s Islamic financials index, in contrast, rose 4.75 per cent in the most recent September quarter and lost a modest 7 per cent in the previous year.

Not only has the industry been resilient; it’s also on the cusp of serious expansion. It is growing faster than any other subset of world banking, at 15 to 20 per cent a year. The Economist estimates Islamic assets under management are worth $US700 billion ($1000 billion). This figure could hit $US1 trillion – about the Australian sharemarket’s current value – by 2010.

What’s more, all this growth has come from a model of lending that rejects interest payments and shuns speculation and heavy borrowing.

In short, Islamic finance bans some of the excess that has brought the West’s financial system to its knees, and is looking wise indeed, or at least lucky.

Islamic finance takes its guidance from sharia.

The biggest markets are in the Middle East and Muslim countries, but global banks have opened sharia-compliant branches. Locally, the Muslim Community Co-operative is one of a few lenders offering the service.

Justice, partnership and opposition to excessive risk are the main principles guiding Islamic banks. Outright speculation and dealing with any party that has a balance sheet more than a third of which is debt are forbidden, as are investments deemed unethical by Islamic scholars, such as casinos.

But if these rules sound tough, the biggest difference is a ban on interest.

Charging interest is immoral because it does not take into account how changes in the value of the loan’s security can affect the borrower, sharia says. Home owners who bought near the peak are now experiencing this harsh reality: interest gives banks a steady payment from the borrower, regardless of the property market’s state.

However, profit is fine, and Islamic banks have devised ways to make money from lending. Instead of demanding interest, they buy the asset outright on behalf of the borrower. The borrower pays off the loan (the principle) and a fee for using the asset (rent, for example) until the amount is repaid and ownership transfers to the borrower.

Just like mortgage-backed securities, the rights to loan repayments can be sold as an Islamic bond, or sukuk. But instead of a yield, the bondholder receives repayments on the loan, and some rent. As a result, Islamic lenders have not had to venture into money markets that have recently blown up.

For depositors, putting your money with an Islamic bank is more like being a shareholder. Rather than interest, depositors get a cut of any profits.

Understandably, Western governments are casting around for ideas on how to run a more robust financial system. But what could they possibly learn from such a different approach?

Islamic finance’s more prudent rules on debt look attractive in hindsight. But more fundamentally, proponents say it provides a better way to link the financial system to the “real” economy.

Because Islamic banks keep ownership of the asset until the loan is repaid, they have a greater incentive to make sure borrowers do not bite off more than they can chew. The bank shares in the risks of the entrepreneur but also its failures, the argument goes.

I am not suggesting we switch to a lending system without interest payments. But a big gripe emerging in recent weeks is that finance has become out of whack with the needs of the rest of the economy.

In the most extreme cases, it seems investment bankers devoted themselves to developing inventive ways to get higher bonuses rather than facilitating productive investment. Islamic finance shows one way of ensuring savings are put to more useful ends.

Some even say banning short selling of shares reflects sharia thinking, because it stops traders dealing with assets they don’t own. “Banning short selling is one of the decisive elements in Islamic finance, so it seems almost that the conventional markets are looking at the Islamic techniques, which so far did not play any role in conventional markets,” a financial journalist from Dubai, Gerard Al-Fil, told ABC radio last month.

Sceptics say Islamic finance just dresses up Western finance with different titles. It is also worth noting that the system is not immune from creating bubbles, although the method of lending makes it harder for investors to pile in through debt. A conflict between its religious goals and the goal of turning a profit is another tension, The Economist notes.

Nevertheless, it is booming. High oil prices have filled the coffers of Gulf states, and the region is crammed with capital works projects in need of funding. Muslims account for 20 per cent of the world’s population, but Islamic finance makes up less than 1 per cent of world capital, suggesting huge room for growth.

The Islamic bond market has tapered off in the credit crunch, but this appears to be a blip. About $US14 billion in Islamic bonds were issued in the eight months to August, down from $US23 billion in the same time last year, but Standard & Poor’s expects issuance to hit $US25 billion next year.

This potential has not crept past Western banks unnoticed, and many have fast-growing sharia-compliant arms. London is vying to capture the market and has changed its laws to allow the different property transfers required for the lending. British media report growing interest even among non-Muslims because of perceptions that it is a more ethical approach to finance.

So expect to see more Islamic banks in years ahead as global banks try to cash in on this growing field. Given the present financial mess, the industry’s resilience only makes it harder to ignore.